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MBA – MBA – Finance Finance IV Trimester Trimester ITM University Sajal Agrawal Visiting Faculty ITM – ITM – School School of Management 1
The capitalisation of a company is the sum total of all long-term long-t erm funds available available to it and also those reserves not meant for distribution among the shareholders.
It comprises
Share Capital Debenture Capital Long-Term Borrowings Free reserves of the company.
In other words, capitalisation represents the permanent investments investments in a company. company. The short-term short-t erm loans are excluded.
The amount of capitalisation which a company should have is related to the earning capacity of the company.
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Fair or normal capitalisation:
Over-capitalisation:
It means business has employed correct amount of capital and its earnings are same as average rate of earnings of the industry.
It means business has employed more capital than required and its earnings are less than the average rate of earnings of the industry.
Under-capitalisation:
It means business has employed Less capital than required and its earnings are more than average rate of earnings of the industry.
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Considering average rate of earnings of an industry is 10% per annum.
Case 1: A company is earning Rs. 1, 00,000 by investing Rs. 10, 00,000, it would be considered as normal capitalised company.
Case 2: If a company is earning Rs. 1, 00,000 by investing Rs. 12, 00,000 then this company will be considered as over-capitalised
Case 3: If a company is earning Rs. 1,00,000 by investing only Rs. 8,00,000, then it is considered as under-capitalised
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Actual profits of the company are not sufficient to pay interest on debentures and borrowings and a fair rate of dividend to shareholders over a period of time.
Suppose a company earns a profit of Rs. 3 lakhs.
Expected earnings of 15% the capitalisation of the company should be Rs. 20 lakhs. But if the actual capitalisation of the company is Rs. 30 lakhs, it will be over-capitalised to the extent of Rs. 10 lakhs. The actual rate of return in this case will go down to 10%.
Since the rate of interest on debentures is fixed, the equity shareholders will get lower dividend in the long-run.
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The amount of capital invested in the company’s business is much more than the real value of its assets.
Earnings do not represent a fair return on capital employed.
A part of the capital is either idle or invested in assets which are not fully utilised.
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Acquisition of Assets at Higher Prices
Higher Promotional Expenses
Underutilisation
Insufficient Provision for Depreciation
Conservative Dividend Policy
Inefficient Management
The shares of the company may not be easily marketable because of reduced earnings per share.
The company may not be able to raise fresh capital from the market.
Reduced earnings may force the management to follow unfair practices. It may manipulate the accounts to show higher profits.
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Management may cut down expenditure on maintenance and replacement of assets. Proper amount of depreciation of assets may not be provided for. Because of low earnings, reputation of the company would be lowered.
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Over-capitalisation results in reduced earnings for the company.This means the shareholders will get lesser dividend. Market value of shares will go down because of lower profitability. There may be no certainty of income to the shareholders in the future. The reputation of the company will go down. Because of this, the shares of the company may not be easily marketable. In case of reorganisation, the face value of the equity share might be brought down.
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The profits of an over-capitalised company would show a declining trend. Such a company may resort to tactics like increase in product price or lowering of product quality.
Return on capital employed is very low. This means that financial resources of the public are not being utilised properly.
An over-capitalised company may not be able to pay interest to the creditors regularly.
The company may not be able to provide better working conditions and adequate wages to the workers.
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The earning capacity of the company should be increased by raising the efficiency of human and non-human resources of the company. Long-term borrowings carrying higher rate of interest may be redeemed out of existing resources.
The par value and/or number of equity shares may be reduced.
Management should follow a conservative policy in declaring dividend and should take all measures to cut down unnecessary expenses on administration.
A company is said to be under-capitalised when it is earning exceptionally higher profits as compared to other companies or the value of its assets is significantly higher than the capital raised.
For instance, the capitalisation of a company is Rs. 20 lakhs and the average rate of return of the industry is 15%. But if the company is earning 30% on the capital investment, it is a case of under-capitalisation.
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There is an unforeseen increase in earnings of the company. Future earnings of the company were underestimated at the time of promotion. Assets might have been acquired at very low prices.
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Acquisition of Assets during Recession
Under-estimation of Requirements
Liberal Dividend Policy
Efficient Management
Creation of Secret Reserves
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The profitability of the company may be very high. As a result, the rate of earnings per share will go up.
The value of its equity share in the market will go up.
The financial reputation of the company will increase in the market.
The shareholders can expect higher dividends regularly.
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Because of higher profitability, the market value of company’s shares would go up. This would also increase the reputation of the company.
The management may be tempted to build up secret reserves.
Higher rate of earnings will attract competition in the market.
The workers of the company may be tempted to demand higher wages, bonus and other benefits.
If a company is earning higher profits, the customers may feel that they are being overcharged by the company.
The government may increase tax rates on companies earning exceptional profits.
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Under-capitalisation may lead to higher profits and higher prices of shares on the stock exchange. This may encourage unhealthy speculation in its shares.
Because of higher profits, the consumer s feel exploited. They link higher profits with higher prices of the products.
The management of the company may build up secret reserves and pay lower taxes to the Government.
Under-capitalisation may be remedied by increasing the par value and/or number of equity shares by revising upward the value of assets. This will lead to decrease in the rate of earnings per share.
Management may capitalise the earnings by issuing bonus shares to the equity shareholders. This will also reduce the rate of earnings per share without reducing the total earnings of the company.
Where under-capitalisation is due to insufficiency of capital, more shares and debentures may be issued to the public.
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Newly Started Company
In case of the new enterprise, the problem is more severe in so far as it requires the reasonable provision for future as well as for current needs and there arises the danger of either raising excessive or insufficient capital.
Established Concern.
But the case is different with established concerns.They have to revise or modify their financial plan either by issuing of fresh securities or by reducing the capital and making it in conformity with the needs of the enterprises.
Cost Theory Earnings Theory
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The capitalisation of a company is determined by adding the initial actual expenses to be incurred in setting up a business enterprise as a going concern. It is aggregate of Cost of fixed assets (plant, machinery, building, furniture, goodwill, and the like) The amount of working capital (investments, cash, inventories, receivables) required to run the business Cost of promoting, organising and establishing the business “If the funds raised are sufficient to meet the initial costs and day to day expenses, the company is said to be adequately capitalised.”
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Cost Theory
Very helpful for the new companies as it facilitates the calculation of the amount of funds to be raised initially.
It gives a concrete idea to determine the magnitude of capitalisation, but it fails to provide the basis for assessing the net worth of the business in real ter ms.
The capitalisation determined under this theory does not change with earnings
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Drawbacks of Cost Theory
It does not take into account the future needs of the business. This theory is not applicable to the existing concerns because it does not suggest whether the capital invested justifies the earnings or not. The cost estimates are made at a particular period of time. They do not take into account the price level changes. For example, if some of the assets may be purchased at inflated prices, and some assets may remain idle or may not be fully utilised, earnings will be low and the company will not be able to pay a fair return on the capital invested. The result will be overcapitalisation. In order to do away with these difficulties and arrive at a correct figure of capitalisation,‘earnings approach’ is used.
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Earning Theory
This theory assumes that an enterprise is expected to make profit.
True Capitalization value depends upon the company’s earnings and/or earning capacity.
Thus, the capitalisation of the company or its value is equal to the capitalised value of its estimated earnings.
To find out this value, a company, while estimating its initial capital needs, has to prepare a projected profit and loss account to complete the picture of earnings or to make a sales forecast
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Earning Theory
Having arrived at the estimated earnings figures, the financial manager will compare with the actual earnings of other companies of similar size and business with necessary adjustments.
After this the rate at which other companies in the same industry, similarly situated are making earnings on their capital will be studied. This rate is then applied to the company’s estimated earnings for determining its capitalisation.
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Earning Theory
Two factors are generally taken into account to determine capitalisation
(i) how much the business is capable of earning (ii) What is the fair rate of return for capital invested in the enterprise.
This rate of return is also known as ‘multiplier’ which is 100 per cent divided by the appropriate rate of return.
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Drawbacks of Earning Theory
More appropriate for going concerns, it is difficult to calculate the amount of capitalisation under this theory. It is based upon a ‘rate’ by which earnings are capitalised. This rate is difficult to estimate in so far as it is determined by a number of factors not capable of being calculated quantitatively.
These factors include nature of industry/ financial risks, competition prevailing in the industry and so on.
New companies cannot depend upon this theory as it is difficult to estimate the expected returns in their case.
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